Heather Dale examines how fixed income has fared through recent market events and how pension funds are now using this core asset class
However, Charles McKenzie, head of fixed income EMEA, Aberdeen Asset Management, said the greater volatility and much wider spreads available in the credit markets were going to throw up interesting opportunities for active fund managers in the years ahead.
"In the short term, there is always the concern things can get worse, but when you look to the medium and longer term, some of the value apparent in the market at the moment looks at an attractive level," McKenzie said.
He noted pension funds were very good at seeing through short term volatility.
"Some pension funds will use the sell-off we have seen in riskier assets such as emerging markets and high yield as a better buying opportunity to start implementing some of these higher outperformance strategies," said McKenzie.
Mark Parry, head of fixed income at Close Investments, said he believed the easy money had been made in financial markets and they were now entering a period of slowing economic growth.
"Within this framework, esoteric structures have been popular, but people are now realising the risks involved with them," said Parry.
Close offers a strategy to investors whereby it believes as well as the capital gains to be made as interest rates fall, it can provide enhanced performance when rates rise: the underlying government bonds provide safety of principle, with secure regular repeatable income, stability, transparency and liquidity.
By actively managing government bonds and then writing options against them, the strategy aims to enhance returns. Parry claimed it was a strategy used in the equity space, but not widely in the bond community.
He added: "It is not magic. It is something a skilled and experienced fund manager should be able to do and gives you an extra tool to utilise to add value, so you don't have to take swinging directional bets on your portfolio."
Pension funds were also asking managers to run with more aggressive strategies, to go for higher returns which would contribute to their long term liabilities.
According to Alan Wilde, head of fixed income at Barings, the way fixed income managers were meeting requirements was by distancing themselves from benchmark relative returns.
"Absolute return strategies are becoming more popular for pension plans and for people who are prepared to allow pension schemes to invest more heavily overseas and to use the skills of managers to get returns from a wider opportunity set," said Wilde.
Liability driven investing
However, McKenzie of Aberdeen said the big picture for pension funds had not changed at all over the last year, as many funds still felt they had to make sure their assets matched their liabilities more closely.
"If anything it is becoming more the norm for pension funds, particularly in the UK and the Netherlands, to start employing liability driven investing (LDI) strategies as a matter of course," said McKenzie.
McKenzie said the reason was that many more managers were offering pooled fund solutions in the area of LDI.
"What was in the realms of larger pension funds doing quite sophisticated hedging strategies and undertaking all their own derivative overlay strategies, in order to hedge their liabilities though LDI strategies, now has definitely evolved," said McKenzie.
However, Jeremy Cave, head of pan-European fixed income, Schroders, said he believed LDI had been an ongoing trend for larger funds for a while, but from mid-summer onwards had slowed because of the volatility in the markets.
Maria Ryan, UK strategist in the fixed income group, Barclays Global Investors, said the closer matching of liabilities ranged from pension funds extending the duration of their existing portfolio to closer match their liabilities, right out to more bespoke tailor-made LDI approaches.
"So what it means is they are reducing the risk on their benchmark versus the liabilities side, and freeing up risk budget," said Ryan. She noted pension funds were now looking for better and higher returns, and had set higher alpha targets than in the past, as funds were now expecting their fixed income assets to work harder.
"This translates into investors taking more risks in fixed income, more global markets for example, rather than just traditional domestic markets, allowing more global positions, and more investment in high yield emerging markets to try and add returns," Ryan said.
Ryan also noted that using only physical assets meant you could often only take meaningful positions on the long side in the credit markets. However, if funds were willing to open up to using derivatives and global markets, they would have many more opportunities to add value.
"The fixed income derivatives market represented US$393trn worth of assets at the end of June 2007, however, the size of the aggregate global fixed income market was only $25trn. [This] just shows the huge increase in fixed income derivatives and the many different opportunities that this brings to add value," said Ryan.
Edith Siermann, head of fixed income, Robeco, added pension funds were hedging their duration risk and said the firm had seen large demand for long duration products. However, she pointed out pension funds did not fully hedge their duration risk, saying only around 50% was hedged and the rest was open to more active duration play to generate alpha.
"Even though in the underlying portfolio pension funds have to match specific currency liabilities, funds are more open to having their alpha generated globally," said Siermann.
It is a tactic Siermann called an 'all strategy' or 'full discretion approach', where alpha could be found anywhere in the world and did not depend on the home currency.
Funds prepared to invest more widely in markets and sub-classes of fixed income had the best chance of making positive returns, according to Wilde of Barings.
"We are recognising some fixed income managers, who are truly global, have the opportunity to make better returns outside the domestic market by mixing sovereign bonds, credit bonds and mortgage backed securities, in a way which is not benchmark driven, but designed to produce positive returns over time, rather than relative returns compared to the benchmark," said Wilde.
Wilde said he had seen this trend growing in particular for local authority pension schemes, with more requests for proposals (RFPs) appearing over the last year than ever before.
Bill Kohli, managing director, Putnam Investments, said he had seen demand from pension funds in countries where sector opportunities were limited, such as Canada, Australia and Singapore, to use satellite strategies to manage against their core benchmark.
"They want their global security selection, but [also want to] stay against their home benchmark," he said.
Kohli believed using derivatives to match the home benchmark, then using assets to do the security selection to add value, made more sense as alpha was driven by more active strategies, including security selection and idiosyncratic ideas. "We have more direct use of capital so we can get a much more robust value-added
portfolio," said Kohli.
Kohli said it was Canadian pension plans and Australian superannuation funds that had been most forward thinking in using this approach. Ironically, he said the US had been less accepting of it.
"Some of the more traditional DB funds are not set up with resources to look at these strategies right away," said Kohli.
According to Kohli, accounting and regulatory changes in the Netherlands and the UK put the impetus on plans to look at liability matching and this had been a real driver to the way they were approaching the market.
Cave of Schroders added bond managers should have the flexibility to invest globally, saying it was another source of return for active managers.
He referred to the principle that the greater the opportunity set, the greater the alpha a manager can bring, saying if a manager was restricted to a domestic market, the potential for alpha could be lower.
Cave concluded: "Fixed income was once regarded as the safe and boring part of the portfolio, it wasn't paid much attention [to], now pension funds have a greater proportion of assets in the portfolio in fixed income and if they want to maintain the return, they have to make it work harder by reducing constraints."
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